CAPITAL GAINS AND LOSSES OF INDIVIDUALS:
AN OVERVIEW

How you are taxed on the gains and losses from your investments?
Several key rules and processes apply.

First, you must separate your long-term gains and losses
from your short-term gains and losses. Long-term, for these
purposes, means gains or losses from investments which you
held for more than a year. Gains and losses from investments
held for one year or less are short-term. In addition, you
must separate your long-term gains and losses into three
rate groups:

(1) the
28% group, consisting of:
· () capital gains and losses from collectibles
(including works of art, rugs, antiques, metals, gems,
stamps, coins, and alcoholic beverages) held for more
than one year;
· (2) long-term capital loss carryovers;
· () section 1202 gain (gain from the sale of certain
small business stock held for more than five years that's
eligible for a 50% exclusion from gross income).
(2) the 25% group, consisting of “unrecaptured section
1250 gain”—that is, gain on the sale of depreciable
real property that's attributable to the depreciation
of that property (there are no losses in this group);
and
(3) the 15%/5% group, consisting of long-term capital
gains and losses that are not in the 28% or 25% group—that
is, most gains and losses from assets held for more than
one year.

Within each of the three groups listed above, gains and
losses are netted to arrive at a net gain or loss.

The following additional netting and ordering rules apply:

Short-term capital losses (including
short-term capital loss carryovers) are applied first
to reduce short-term capital gains, if any, otherwise
taxable at ordinary rates. If you have a net short-term
capital loss, it reduces any net long-term gain from
the 28% group, then gain from the 25% group, and finally
reduces net gain from the 15%/5% group.

Long-term capital gains and losses are
handled as follows. A net loss from the 28% group (including
long-term capital loss carryovers) is used first to
reduce gain from the 25% group, then to reduce net gain
from the 15%/5% group. A net loss from the 15%/5% group
is used first to reduce gain from the 28% group, then
to reduce gain from the 25% group.

If, after the above netting, you have any long-term capital
gain, the gain that's attributable to a particular rate
group is taxed at that group's marginal tax rate—28%
for the 28% group, 25% for the 25% group, and the following
rates for the 15%/5% group:

5% in the case of gain that would otherwise
be taxed at a regular tax rate below 25%, i.e., at 10%
or 15%;

15% in the case of gain not subject
to the 5% rate described above.

If, after the above netting, you're left with short-term
losses or long-term losses (or both), you can use the losses
to offset ordinary income, subject to a limit. The maximum
annual deduction against ordinary income for the year is
$3,000 ($1,500 for married taxpayers filing separately).
Any loss not absorbed by the deduction in the current year
is carried forward to later years, until all of it is either
offset against capital gains or deducted against ordinary
income in those years, subject to the $3,000 limit. If you
have both net short-term losses and net long-term losses,
the net short-term losses are used to offset ordinary income
before the net long-term losses are used.

Dividends taxed at long-term capital gains rates
Dividends that you receive from domestic corporations and
“qualified foreign corporations” are taxed at
the same rates that apply to 15%/5% group mentioned above.
However, these dividends aren't actually part of that group,
and aren't subject to the grouping and netting rules discussed
above.

Some planning suggestions
Since losses can only be used against gains (or up to $3,000
additionally), in many cases, matching up gains and losses
can save you taxes. For example, suppose you have already
realized $20,000 in capital gains in Year 1 and are holding
investments on which you have lost $20,000. If you sell
the loss items before the end of the year, they will “absorb”
the gains completely. Alternatively, if you wait to sell
the loss items in Year 2, you will be fully taxed on Year
1 gains and will only be able to deduct $3,000 of your losses
(if you have no other gains in Year 2 against which to net
the losses).

Another technique is to seek to “isolate”
short-term gains against long-term losses. For example,
say you have $10,000 in short-term gains in Year 1 and $10,000
in long-term losses as well. You're in the highest tax bracket
in all relevant years (assume that's a 35% bracket for Year
1). Your other investments have been held more than one
year and have gone up $10,000 in value, but you haven't
sold them. If you sell them in Year 1, they will be netted
against the long-term losses and leave you short- term gains
to be taxed at 35%. Alternatively, if you can hold off and
sell them in Year 2 (assuming no other Year 2 transactions),
the losses will “absorb” the short-term gains
in Year 1. In Year 2, the long-term gains will then be taxed
at only 15% (unless the gains belong in the 25% or 28% group).

Family tax planning opportunity
Given the 5% capital gains rate for low bracket taxpayers,
if you have appreciated stock or other capital assets that
you are thinking of selling, you may wish to consider transferring
the asset to children over 13. To the extent their other
taxable income would be taxed at a regular tax rate of less
than 25% (i.e., for 2004, taxable income of less than $29,050
for single returns), they can take advantage of the 5% rate
for net capital gains. (For children under 14 the “kiddie
tax” rules can cause the child's income to be taxed
at the parent's higher tax rates.)

Alternative minimum tax
The favorable rates that apply to long-term capital gain
(and qualified dividend income) for regular tax purposes
also apply for alternative minimum tax (AMT) purposes. In
spite of this, any long-term capital gains you recognize
in a year might trigger an AMT liability. This can happen
if the capital gains increase your total income enough so
that your AMT exemption phases out. The extra income from
capital gains may also affect your entitlement to various
exemptions, deductions and credits, and the amounts of those
AMT preferences and adjustments, that depend on the amount
of your income.